Chapter 15

Property Transactions: Nontaxable Exchanges

Individual Income Taxes

Copyright ©2006 South-Western/Thomson Learning

Nontaxable Transactions

(slide 1 of 4) • In a nontaxable transaction, realized gain or loss is not currently recognized – Recognition is postponed to a future date (via a carryover basis) rather than eliminated

Individual Income Taxes

C15 - 2

Nontaxable Transactions

(slide 2 of 4) • In a tax-free transaction, nonrecognition of realized gain is permanent

Individual Income Taxes

C15 - 3

Nontaxable Transactions

(slide 3 of 4) • Holding period for new asset – The holding period of the asset surrendered in a nontaxable transaction carries over to the new asset acquired

Individual Income Taxes

C15 - 4

Nontaxable Transactions

(slide 4 of 4) • Depreciation recapture – Potential recapture from the asset surrendered carries over to the new asset acquired in the transaction

Individual Income Taxes

C15 - 5

Like-Kind Exchanges

(slide 1 of 9) • §1031 requires nontaxable treatment for gains and losses when: – Form of transaction is an exchange – Assets involved are used in trade or business or held for production of income • However, inventory, securities, and partnership interests do not qualify – Asset exchanged must be like-kind in nature or character as replacement property

Individual Income Taxes

C15 - 6

Like-Kind Exchanges

(slide 2 of 9) • Like-kind property defined – Interpreted very broadly • Real estate for real estate – Improved for unimproved realty qualifies – U.S. realty for foreign realty does not qualify • Tangible personalty for tangible personalty – Must be within the same general business asset or product class – Livestock of different sexes does not qualify

Individual Income Taxes

C15 - 7

Like-Kind Exchanges

(slide 3 of 9) • Exchange requirement – The transaction must involve a direct exchange of property to qualify as a like-kind exchange – If the exchange is a delayed (nonsimultaneous) exchange, there are time limits on its completion • The new property must be identified within 45 days of the date when the old property was transferred • The new property must be received by the earlier of the following: – Within 180 days of the date when the old property was transferred – The due date (including extensions) for the tax return covering the year of the transfer

Individual Income Taxes

C15 - 8

Like-Kind Exchanges

(slide 4 of 9) • Boot – Any property involved in the exchange that is not like-kind property is “boot” – The receipt of boot causes gain recognition equal to the lesser of boot received (FMV) or gain realized • No loss is recognized even when boot is received

Individual Income Taxes

C15 - 9

Like-Kind Exchanges

(slide 5 of 9) • Boot – The transferor of boot property may recognize gain or loss on that property • Treat as if boot property sold for its FMV

Individual Income Taxes

C15 - 10

Like-Kind Exchanges

(slide 6 of 9) • Basis in like-kind asset received: FMV of new asset – Gain not recognized + Loss not recognized = Basis in new asset • Basis in boot received is FMV of property

Individual Income Taxes

C15 - 11

Like-Kind Exchanges

(slide 7 of 9) • Basis in like-kind property using Code approach Adjusted basis of like-kind asset given + Adjusted basis of boot given + Gain recognized – FMV of boot received – Loss recognized = Basis in new asset

Individual Income Taxes

C15 - 12

Like-Kind Exchanges

(slide 8 of 9) • Example of an exchange with boot: – Zak and Vira exchange equipment of same general business asset class – Zak: Basis = $25,000; FMV = $40,000 – Vira: Basis = $20,000; FMV = $30,000 – Vira also gives securities: Basis = $7,000; FMV = $10,000

Individual Income Taxes

C15 - 13

Like-Kind Exchanges

(slide 9 of 9) • Example of an exchange with boot (cont’d): – Zak has a $10,000 recognized gain; $25,000 basis in the equipment, $10,000 in the securities – Vira has a $3,000 recognized gain; $30,000 basis in the equipment

Individual Income Taxes

C15 - 14

Involuntary Conversions

(slide 1 of 13) • §1033 permits (i.e., not mandatory) nontaxable treatment of gains if the amount reinvested in replacement property

equals or exceeds

the amount realized • If the amount reinvested in replacement property is

less than

the amount realized, realized gain

is recognized

to the extent of the deficiency

Individual Income Taxes

C15 - 15

Involuntary Conversions

(slide 2 of 13) • §1033 requirements – Replacement property must be similar or related in service or use as involuntarily converted property – Replacement property must be acquired within a specified time period

Individual Income Taxes

C15 - 16

Involuntary Conversions

(slide 3 of 13) • Involuntary conversion defined – The destruction, theft, seizure, condemnation, or sale or exchange under threat of condemnation of property • A voluntary act by taxpayer is not an involuntary conversion

Individual Income Taxes

C15 - 17

Involuntary Conversions

(slide 4 of 13) • Replacement property defined – Must be similar or related in service or use as the converted property – Definition is interpreted very narrowly and differently for owner-investor than for owner user – For business or investment real estate that is condemned, replacement property has same meaning as for like-kind exchanges

Individual Income Taxes

C15 - 18

Involuntary Conversions

(slide 5 of 13) • Taxpayer use test (owner-investor) – The properties must be used by the owner in similar endeavors • Example: Rental apartment building can be replaced with a rental office building because both have same use to owner (the production of rental income)

Individual Income Taxes

C15 - 19

Involuntary Conversions

(slide 6 of 13) • Functional use test (owner-user) – The property must have the same use to the owner as the converted property • Example: A manufacturing plant is not replacement property for a wholesale grocery warehouse because each has a different function to the owner-user

Individual Income Taxes

C15 - 20

Involuntary Conversions

(slide 7 of 13) • Time period for replacement – Replacement time period starts when involuntary conversion or threat of condemnation occurs – Replacement time period ends 2 years (3 years for condemnation of realty) from the year-end of year that gain is realized

Individual Income Taxes

C15 - 21

Involuntary Conversions

(slide 8 of 13) • Example of time period for replacement – Taxpayer’s office is destroyed on November 4, 2002 – Taxpayer receives insurance proceeds on February 10, 2003 – Taxpayer is a calendar-year taxpayer – Taxpayer’s replacement period is from November 4, 2002 to December 31, 2005

Individual Income Taxes

C15 - 22

Involuntary Conversions

(slide 9 of 13) • Nonrecognition of gain: Direct conversions – Involuntary conversion rules mandatory – Basis and holding period in replacement property same as converted property

Individual Income Taxes

C15 - 23

Involuntary Conversions

(slide 10 of 13) • Nonrecognition of gain: Indirect conversions – Involuntary conversion rules elective – Gain recognized to extent amount realized (usually insurance proceeds) exceeds investment in replacement property

Individual Income Taxes

C15 - 24

Involuntary Conversions

(slide 11 of 13) • Nonrecognition of gain: Indirect conversions – Basis in replacement property is its cost less deferred gain – Holding period includes that of converted property

Individual Income Taxes

C15 - 25

Involuntary Conversions

(slide 12 of 13) • Involuntary conversion rules do not apply to losses – Losses related to business and production of income properties are recognized – Personal casualty and theft losses are recognized (subject to $100 floor and 10% AGI limit); personal use asset condemnation losses are not recognized or postponed

Individual Income Taxes

C15 - 26

Involuntary Conversions

(slide 13 of 13) • Involuntary conversion of personal residence – Gain from casualty, theft, or condemnation may be deferred as involuntary conversion (§1033) or excluded as sale of residence (§121) – Loss from casualty recognized (limited); loss from condemnation not recognized

Individual Income Taxes

C15 - 27

Sale of Residence

(slide 1 of 6) • Loss on sale – As with other personal use assets, a realized loss on the sale of a personal residence is not recognized

Individual Income Taxes

C15 - 28

Sale of Residence

(slide 2 of 6) • Gain on sale – Realized gain on sale of principal residence is subject to taxation – Realized gain may be partly or wholly excluded under §121

Individual Income Taxes

C15 - 29

Sale of Residence

(slide 3 of 6) • §121 provides for exclusion of up to $250,000 of gain on the sale of a principal residence • Taxpayer must own and use as principal residence for at least 2 years during the 5 year period ending on date of sale

Individual Income Taxes

C15 - 30

Sale of Residence

(slide 4 of 6) • Amount of Exclusion – $250,000 maximum – Realized gain is calculated in normal manner – Amount realized on sale is reduced by selling expenses such as advertising, broker’s commissions, and legal fees

Individual Income Taxes

C15 - 31

Sale of Residence

(slide 5 of 6) • Amount of Exclusion (cont’d) – For a married couple filing jointly, the $250,000 max is increased to $500,000 if the following requirements are met: • Either spouse meets the 2 year ownership req’t, • Both spouses meet the 2 year use req’t, • Neither spouse is ineligible due to the sale of another principal residence within the prior 2 years

Individual Income Taxes

C15 - 32

Sale of Residence

(slide 6 of 6) • §121 cannot be used within 2 years of its last use except in special situations: • Change in place of employment, • Health, • Other unforeseen circumstances • Under these circumstances, only a portion of the exclusion is available, calculated as follows: Max Exclusion amount × number of qualifying months 24 months

Individual Income Taxes

C15 - 33

Other Nonrecognition Provisions

(slide 1 of 7) • Several additional nonrecognition provisions are available: – Under §1032, a corporation does not recognize gain or loss on the receipt of money or other property in exchange for its stock (including treasury stock)

Individual Income Taxes

C15 - 34

Other Nonrecognition Provisions

(slide 2 of 7) • Under §1035, no gain or loss is recognized from the exchange of certain insurance contracts or policies

Individual Income Taxes

C15 - 35

Other Nonrecognition Provisions

(slide 3 of 7) • Under §1036, a shareholder does not recognize gain or loss on the exchange of common stock for common stock or preferred stock for preferred stock in same corporation

Individual Income Taxes

C15 - 36

Other Nonrecognition Provisions

(slide 4 of 7) • Under §1038, no loss is recognized from the repossession of real property sold on an installment basis – Gain is recognized to a limited extent

Individual Income Taxes

C15 - 37

Other Nonrecognition Provisions

(slide 5 of 7) • Under §1041, transfers of property between spouses or former spouses incident to divorce are nontaxable

Individual Income Taxes

C15 - 38

Other Nonrecognition Provisions

(slide 6 of 7) • Under §1044, if the amount realized from the sale of publicly traded securities is reinvested in common stock or a partnership interest of a specialized small business investment company, realized gain is not recognized – Amounts not reinvested will trigger recognition of gain to extent of deficiency – Statutory limits are imposed on the amount of gain qualified for this treatment – Only individuals and C corporations qualify

Individual Income Taxes

C15 - 39

Other Nonrecognition Provisions

(slide 7 of 7) • Under §1045, realized gain from sale of qualified small business stock held > 6 months may be postponed if other qualified small business stock is acquired within 60 days • Qualified small business stock is stock acquired at its original issue for money, other property, or services from a domestic corp with assets that do not exceed $50 million before or after the issuance of small business stock

Individual Income Taxes

C15 - 40

If you have any comments or suggestions concerning this PowerPoint Presentation for West Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

Individual Income Taxes

C15 - 41